Bubble trouble? Or not?

Sunday

Nov 24, 2013 at 2:00 AM

Do we have a stock market bubble or not? That's the question many investors are asking as the stock market continues its steady climb upward. The answer? It depends on which corners of the market you look at.

BARRY PASTER

Do we have a stock market bubble or not? That's the question many investors are asking as the stock market continues its steady climb upward. The answer? It depends on which corners of the market you look at.

If you look at the frenzy surrounding tech initial public offerings, like Twitter, yes, there is an inflating bubble, reminiscent of the dotcom bubble days of the late '90s.

At its IPO, Twitter had no profits, an unproven revenue model and still uncertain user growth. The stock was initially priced at roughly 28 times revenue — not earnings, revenues. It then nearly doubled during its first day of trading before settling back by the end of the day.

The best case analysts can make based on fundamentals is a valuation less than half of Twitter's current market price of about $42 a share. And that's a stretch. Similar analysis applies to companies like Facebook, Tesla, LinkedIn and Amazon.

So, yes, that corner of the market is in bubble territory.

But most of the rest of the stock market is still relatively reasonably priced. Analysts use a lot of metrics to measure broad market valuations, including trailing-year price-to-earnings ratios (PEs), predicted PEs for next year, discounted cash flows, economic prospects and more.

But those valuations are mostly skewed by a handful of mainly large cap companies, like some of those mentioned above, plus Google, Apple and others.

So the best way to look at it is more granularly, company-by-company.

Even from that point of view, it's true that most stocks are fully valued. They're not overpriced, but they're not cheap. There are many fewer undervalued companies around than there were a couple of years ago, or even at the beginning of this year. So it's gotten harder to find bargains. Still, compared to the late '90s, stocks overall are not a bubble about to be popped.

Yes, there will be market corrections. Some may even be steep. Stocks reacted badly when the Federal Reserve started to verbally wrestle with how to prepare the markets for tapering its bond buying. So the Fed is now trying to fine-tune its message and make clearer that the beginning of tapering doesn't mean rising interest rates are inevitable any time soon.

Regardless, when the Fed actually begins to taper, it's reasonable to expect a stock market correction of some sort. But, of course, the market has a habit of doing just the opposite of what everyone expects. So no one can predict what will happen or when.

There are also some more nuanced cross-currents.

For example, amid the dismal fixed income yields of the last couple of years, many investors have used blue chip stocks with nice dividend yields as virtual substitutes for bonds. Companies like Coca-Cola, PepsiCo, Dominion Resources, Johnson & Johnson and Procter & Gamble currently sport stock dividend yields that are higher than their short and intermediate bonds yield. In response to the added demand, their stocks have risen higher than they would have otherwise.

Consequently, as the interest-rate driven part of this stock market rally subsides, some of those kinds of stocks may fall a bit — a classic rotation. They're already showing signs of weakening on days when market interest rates spike up.

Any market correction that occurs won't be the last investors see in their lifetimes. But market corrections pass. And, at least so far, there are plenty of other economic fundamentals to sustain stocks longer term, as the U.S. continues to dig out from the economic crisis of five years ago.

None of this is to say that some unforeseen political or economic event won't cause a sudden reversal. But even that is likely to be short-lived. Investors shouldn't forget that the depths of the economic crisis and stock market meltdown were less than five years ago. Despite lingering vestiges, the crisis has largely passed, and stocks have returned to historical growth rates.

Meanwhile, if investors really want to find a broad-based asset bubble, they only need look at fixed income securities, like CDs, U.S. Treasuries, corporate bonds and preferred stocks. Those securities will wilt when interest rates signal they're really ready to rise.

(Disclaimer: my firm owns stocks mentioned in this column on behalf of many of our clients.)

Barry Paster owns Bridge Creek Capital Management LLC, a fee-only stock and bond portfolio manager. His column also appears on www.capecodonline.com. He may be reached at P.O. Box 648, West Barnstable, MA 02668; by phone at 508-362-9566; and by email at management@bridgecreekcapital.com.

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